David Rosenberg: Why the Bank of Canada needs to start cutting rates … Now

The most important inflation metric, the CPIX, which excludes the eight most volatile segments of the index, is running at 2.1 per cent on a year-over-year basis. That is pretty well on target, barely higher than the pre-COVID-19 trend, and less than half the pace of a year ago.

The year-over-year retail price index has gone from more than two per cent a year ago to flat today. There is absolutely no pricing power at all in the Canadian retail sector.

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Real gross domestic product growth in the past year is running at 0.9 per cent, even with population gains running at 3.2 per cent year over year. The math works out to a decay in real output per capita of two per cent at an annual rate.

The unemployment rate, at 6.1 per cent, is higher today than it was pre-COVID-19, when the policy rate was 1.75 per cent, not five per cent. It is up a full percentage point on a year-over-year basis, which points to elevated 80 per cent recession odds. The ranks of unemployment have surged 23 per cent over the past 12 months as the number of people entering the labour force has nearly doubled the number of folks actually landing a job. Nothing here spells a future of accelerating wage inflation — quite the opposite.

Another measure of economic slack, the employment-to-population ratio, at 61.4 per cent, compares to the 62.1 per cent pre-COVID-19 level. Not only that, but the broadest form of unemployment that includes all measures of idle labour resources, otherwise known as the R-8 jobless rate, now stands at 8.8 per cent versus 7.5 per cent a year ago. That is nearly where it was in the comparable 2019 period (the data are not seasonally adjusted, so they have to be compared with March of prior years for comparative purposes), when, yet again, the Bank of Canada was pinning the overnight rate at 1.75 per cent.

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The industry-wide capacity utilization rate (the employment rate equivalent for the business sector) is down to 78.7 per cent, the lowest (most disinflationary) since the fourth quarter of 2020. The pre-COVID-19 level was near 80 per cent — again, when the policy rate was 325 basis points below where it resides today.

Inflation-phobes should recognize that, on a year-over-year basis, because of this excess of supply over demand, producer prices in Canada are running at minus 0.5 per cent and at minus 0.2 per cent for the core (ex-energy) index.

Bank of Canada behind the curve

The Bank of Canada's own estimate of potential non-inflationary growth from now to 2027 is 1.8 per cent at an annual rate. The economy is now running at half that pace. Ergo, the primary risk in Canada is homegrown deflation as excess capacity builds, not inflation.

In last year's fourth quarter, the disinflationary "output gap" in Canada was estimated at minus 0.7 per cent and that came after a minus 0.1 per cent deviation between actual real GDP and the level that would be consistent with inflationary pressure. This is a classic measure of overall economic slack. And since that time, the "gap" has only continued to widen.

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The Bank of Canada is below the disinflation curve almost as much as it was behind the inflation curve back in 2021 and early 2022. Going back over the past quarter-century, an output gap of any size rarely coincided with a five per cent policy rate, and on average, the central bank was pegging that rate closer to two per cent. No matter how you slice it or dice it, the Bank of Canada is keeping policy far too tight. It may be true that the United States Federal Reserve is on a different course, but then again, the U.S. economy is running at more than triple the pace of Canada's.

Debt service costs soar

In aggregate, Canadians are shelling out 15 cents of every after-tax dollar on debt service. That is right at, or higher than, the punishing levels that presaged each of the past four recessions dating back to 1990. The future is one of a cycle of debt-deleveraging and defaults, and that, again, is a deflationary development.

The Bank of Canada's estimate of R-star (or the "neutral" nominal policy rate) is between 2.25 per cent and 3.25 per cent. The midpoint, at 2.75 per cent, means the central bank is 225 basis points "too tight." Its rate is 175 basis points higher than the high end of that band, for crying out loud.

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At the same time, policymakers acknowledged at their April 10 policy meeting that "the economy moved into excess supply." If anything, an economy that has moved into such a disinflationary "output gap" should have the overnight rate below the midpoint of that R-star range, not 225 basis points above that estimate.

Go long on bonds

The message: Go long on the Government of Canada bond market, with the biggest yield declines to come at the front end of the curve and the greatest total net return at the back end due to convexity and duration. This should be good news for the banks as well as other rate-sensitives such as pipelines, real estate investment trusts (selectively) and utilities.

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And with the Fed on hold for many months to come, interest rate differentials in favour of the U.S. dollar will be keeping the Canadian dollar under downward pressure — good news here for exporters and tourist operators.

David Rosenberg is founder and president of independent research firm Rosenberg Research & Associates Inc. To receive more of David Rosenberg's insights and analysis, you can sign up for a complimentary, one-month trial on the Rosenberg Research website.

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